Question

Using an income-leisure tradeoff model graph, illustrate the income and substitution effects of a wage decrease. The income effect dominates the substitution effect. Lable and indicate the effects clearly.

Answer 1

The income effect of a rise in the hourly wage rate

• Positive income effect: When higher wages cause people to want to work more hours in order to reach a target / desired income
• Negative income effect: When a target income has been reached and people prefer spending more time on leisure rather than earning more income

The substitution effect of a rise in the hourly wage rate

• A rise in the real wage increases the opportunity cost of leisure
• Therefore higher wages will always cause people to be incentivised to work longer hours via the substitution effect
• But the income effect may work in the opposite direction

Some people may have a backward bending individual labour supply curve – they may choose to work fewer hours when the wage rate rises (ceteris paribus)